The Biggest Dividends Aren’t Necessarily the Best

An Amgen plant in Thousand Oaks, Calif. Amgen, the biotech company, and Roche, the pharmaceutical giant, have raised dividend payouts.CreditAmgen

By Norm Alster

April 4, 2014

RISK-AVERSE investors seeking steady income have had little to cheer about in recent years.

Waiting for Godot may have been less frustrating than waiting for interest rates to rise on conservative financial instruments like certificates of deposit and savings accounts.

Still, many people found solace in dividend-paying stocks and the mutual funds and exchange-traded funds that hold them. In a sign of the popularity of dividends, money poured into income-producing stock mutual funds through 2011, 2012 and most of 2013.

But in September, the mood of investors apparently changed: The fund flows reversed, according to Jeff Tjornehoj, head of Americas research at Lipper, and cash flowed out of these funds late last year and early this year.

As Stuart Reeve, the lead manager of the BlackRock Global Dividend fund, who is based in London, has noted, “Expectations of rate hikes have people worrying about dividend-paying stocks.” That’s because some dividend-paying stocks behave like bonds: When rates rise, their value often drops.

There is certainly no shortage of choices for dividend hunters. Large dividend E.T.F.s include iShares Select Dividend, which features high-yield stocks, and SPDR S&P Dividend, which holds stocks that have raised their dividends in each of the last 20 years.

The iShares Select Dividend E.T.F. produced a total return of 28.85 percent last year, according to Morningstar, while SPDR S&P Dividend fared a bit better, returning just over 30 percent; both fell slightly short of the broader market’s huge gains. Both funds outperformed the Standard & Poor’s 500-stock index in the first quarter.

So dividend-hunting has not lost its appeal.But some asset managers say they believe that ferreting out stocks simply because they offer the highest yield may not be the way to go if rates do rise.

“If you’re just investing for yield, rising interest rates would have an impact,” a negative one, Mr. Reeve said.

That’s why some fund managers and investors foresee a shift in focus from high-yielding stocks to those that may offer lesser yields but show a more consistent pattern of dividend growth.

“We think dividend growers are the place to be in such an environment,” said Scott Moore, a manager of the Buffalo Dividend Focus fund.

Michael Jones, chairman and chief investment officer of the RiverFront Investment Group, says he expects dividend growers to “return close to 7 percent over inflation” over the next 5 to 10 years, substantially outperforming “low-volatility, high-dividend stocks,” which he thought “would return closer to 2 percent over inflation.”

Included in that low-volatility, high-dividend group are utilities and telecommunications and consumer staples companies. Typically, these companies promise only modest growth.

Geoff Considine, a consultant to asset managers who is based in Boulder, Colo., says high-yield stock investing offers the benefit of relatively low risk. “It looks as though dividends give you all the benefits of value investing with less market risk,” he said.

But low-growth, high-dividend stocks can become overvalued. “The biggest concern with dividend investing is when people become indiscriminate, buying dividend stocks without regard to other metrics,” Mr. Considine added.

That has already happened, in Mr. Jones’s view. “High-dividend, low-volatility stocks, he said, are about as overvalued as they have been since the ’20s.” And tighter monetary policy by the Federal Reserve will lead to higher bond yields, he said.

“When that happens, high-dividend, low-volatility stocks will do much worse than the S.&P. 500,” Mr. Jones added.

Stocks with growing dividends are in a different class from traditional high-dividend payers, he said. “The reason dividend growth is important,” he explained, “is that it is a strong signal from management that corporate earnings are on a strong track, the balance sheet is powerful and they are confident enough to make a cash-flow commitment to shareholders.”

Technology companies, which traditionally eschewed dividends, have lately been joining this class of dividend growers. Both Apple and Microsoft, for example, have rapidly raised payouts after recently beginning to pay dividends.

Amgen, the biotech company, is another example. Scott Davis, lead manager of the Columbia Dividend Income fund, says he is glad that he bought the stock in 2011. Amgen initiated a dividend that year and has since increased it to 61 cents a quarter from 28 cents.

Companies that begin paying dividends — however small — interest Mr. Davis. “When a company initiates a dividend, it’s usually below what they can do,” he said, and dividend growth often follows.

His Columbia Dividend Income portfolio is thick with pharmaceutical companies, including Pfizer, Merck and Johnson & Johnson. Worries about patent expirations have clouded the general outlook for drug makers in recent years, but Mr. Davis says investors are beginning to see new potential. “It now appears that the pipelines for new drugs are much fuller than many thought,” he said.

Mr. Reeve of BlackRock sees expanding opportunity for drug makers globally. “Access to drugs is increasing outside of the developed world,” he said, specifically citing Asia and Latin America. Roche Holding, one of the fund’s largest positions, offers a yield of just under 3 percent and has been raising its dividend for the last five years at an annual rate of better than 9 percent.

The BlackRock fund can invest anywhere in the world, but its holdings are concentrated in Europe and North America. “The valuations right now are better in the U.S. and Europe than in Asia,” Mr. Reeve explained.

A HISTORY of dividend growth is essential to some dividend asset managers. But Ray Nixon Jr., lead manager of the Transamerica Dividend Focused fund, emphasizes companies whose dividend growth is likely to excel in the future. “We want dividend growth to exceed S.&P. 500 dividend growth,” he said.

The fund has fared well this year with a heavy weighting in banks. It holds JPMorgan Chase, which has restored its dividend to 38 cents a quarter, its level before the financial crisis, despite the bank’s recent problems with the federal government. Over the last year or so, JPMorgan Chase paid roughly $20 billion in penalties to federal authorities to settle a variety of claims. Yet there was enough cash to pay the dividend.

Any eventual easing in governmental scrutiny of banks offers the “potential for surprises to the upside,” Mr. Nixon said. Then, he said, stronger operating results should lead to dividend growth.

A version of this article appears in print on , on Page BU18 of the New York edition with the headline: The Biggest Dividends Aren’t Necessarily the Best. Order Reprints | Today’s Paper | Subscribe